Monday, December 06, 2010

Why we run deficits

At the federal level, center-left types fought an entire national election in 2000 based largely on the idea that times were good and the federal government should be accumulating surpluses. It was a pretty big deal, and as you'll recall, we center-lefties lost that election and George Bush proceeded to piss away the surplus and run up more debt than any president in history. On the spending side, center lefties recently passed a big healthcare overhaul that was largely funded by cuts in Medicare spending, and instead of applause for their fiscal sobriety they got hammered for it by Republicans during the 2010 midterms. In other words, on the federal level center-left types have proven over and over that they are willing to be pretty responsible on spending and budgetary issues despite getting clobbered for it. But the opposite isn't true of conservatives and taxes. One need look no further than the national-level dogfight going on right now over the expiration of the deficit-busting tax cuts that originally got George Bush into the White House. No conservative who wants to win reelection even dares consider taking a responsible position on this.

But how are things at the state level? What happens when center-lefties try to restrain spending and build up surpluses during good times? They very quickly learn a harsh lesson: if you accumulate money in a rainy-day fund, conservatives will promptly demand that it be "returned to the taxpayers." That happened here in California as far back as 1978 and was a big reason for the passage of Proposition 13. And if you allow a temporary tax cut to expire, your career might be over. This happened here in California as recently as 2003, when Gray Davis got tossed out on his ear for allowing the car license fee to automatically revert to its old level when the state budget got out of balance.

Nobody is an angel in this fight, and certainly liberals could do a better job of speaking out for spending restraint during boom times. But conservatives have made it largely pointless to build up federal surpluses or state rainy day funds even when lefties are feeling in a responsible mood. At the same time, conservatives have also made it career-threateningly dangerous to allow even temporary tax cuts to expire. It's true that there's always a steady hum of background pressure from interest groups to maintain spending levels, much of it from the left, but for the most part the really pointed incentives come from the conservative side and simply aren't symmetrical: they always run in favor of tax cuts and against spending restraint.

The whole idea of trying to balance budgets over the business cycle is practically a center-left platitude. The fact that it doesn't happen very often is attributable in small part to basic human nature (nobody likes to restrain spending when money is available) and in very large part to the fact that conservatives flatly won't let it happen.

This is very true. But Drum ignores the question of why. Do conservatives support big deficits because the conservative philosophy of government says deficits are good? Is it because naturally irresponsible human beings are drawn to the Republican party? Or is it because the outcome of some political bargaining game (the "two Santas" theory) forces Republicans to promise more goodies than Democrats?

I'm not sure, but here is an important point that many Americans fail to realize: All rich countries have run huge deficits in the past 30 years, from socialist France to conservative Japan. The U.S. is in no way unique. There appear to be no fiscal hawks in power anywhere in the developed world.

To me, this is a signal that the root cause of rich-world deficits goes far deeper than the vagaries of a single nation's politics or the ideology of any one faction. Something happened to the world that made it impossible for rich-world governments to balance their budgets. That something, I am guessing, is capital mobility.

In the branch of economics called "public choice theory," a well-known result is that there are only two ways to pay for public services (i.e. public goods whose costs depend on the number of people using the good): 1) make the rich people pay more than they'd offer to pay, or 2) run a big deficit. This is called the "Groves-Clarke" result. When a government pays for its services by holding a gun to rich people's heads, it's called an "AGV mechanism," and when it runs a deficit, it's called a "Groves-Clarke mechanism". See here for the math if you're interested.

Before 1980, we basically held a gun to our rich people's heads and said "Pay up." Top marginal tax rates were over 90%. Corporate taxes were high. This situation was essentially the same in Europe and Japan. But around 1980, something big changed: capital mobility. Global rules changed, and financial markets opened, allowing rich people to move their money wherever they saw fit. This basically gave rich folks an outside option; if taxes were too high, they could move their money elsewhere.

If the rich people have an outside option, AGV doesn't work - the only way to pay for government is to run deficits (Groves-Clarke). Thus, when world capital markets opened, deficits appeared in all rich countries and have persisted ever since. Naturally, this is a problem, since it logically ends in all rich countries defaulting on their debts, after which they will either drastically slash government services ("austerity") or close their capital markets and go back to forcing the rich people to fork over the loot.

This is a rather depressing explanation for why rich countries run big deficits, but I think it is the right one. Republicans have been more willing to run deficits, but that is probably just because they represent the rich people who will move their money out of the country if taxes are raised to balance the budget. We probably confront a devil's choice between closing our capital markets (and thus hurting international trade) or deeply cutting public services like roads and schools - things that are a net positive for the country, but that aren't worth the price to the rich.